"Qualified Income Offset" Under Trea. Reg. 1.704

LLC's taxed as partnerships must meet the "substantial economic effect" test of Treasury Reg. § 1.704-1(b)(2) for the allocation of income, losses and other items. This is an especially important point in regard to pass-through LLC losses as a deduction could be denied by the IRS if it finds the allocation lacks substantial economic effect. There are two alternative tests for providing that allocations by an LLC have substantial economic effect.

Under the first test, the LLC operating agreement must unconditionally obligate all members with a negative capital account to restore the amount of such deficit balance to the LLC by the end of the taxable year during which liquidation occurs (or, if later, within 90 days after the date of such liquidation). Treas. Reg. § 1.704-1(b)(2)(ii)(b)(3). One of the main reasons people find the LLC form attractive for business is it's limited liability feature. If the operating agreement requires all members to repay capital account deficits upon the liquidation of the LLC, this could make them liable to some degree for LLC debts. For obvious reasons, this is not an attractive option for complying with the substantial economic effect requirement.

The alternate test for substantial economic effect is less draconian. It requires the LLC operating agreement to contain a "qualified income offset" (in addition to other requirements). In laymans terms (to the best of my reading of the regulations), a qualified income offset merely suspends any special allocations to an LLC member that would increase a capital deficit and requires the LLC to allocate income or gain to the member to eliminate any the negative capital account as quickly as possible. For an example of such a provision, see this operating agreement at Section 6.2(c). Another common way one sees for addressing "qualified income offset" requirement in LLC operating agreement is including the following short phrase: "To the extent a Member shall have a negative capital account balance, there shall be a qualified income offset, as set forth in Treasury Regulation 1.704-l(b)(2)(ii)(d)." I personally prefer more of an explanation of what the offset entails but I have seen no ruling for the IRS indicating that this phrase is inadequate. For more extensive sample language, click here and language contained in PLR 145623-04.

For more on this topic, see Federal Income Taxation of LLC Members By Charles R. Beaudrot.

Fudging Loan Application Of LLC

Question: I'm a 1/3 partner in an LLC - we are having credit problems getting a loan because of my credit - not too bad, just not good enough. We need this $65,000 loan for biz improvements - the broker suggested taking me off the LLC paperwork just until the loan is approved then putting me back on. Your thoughts or suggestions would be greatly appreciated. thank you. Barry, CA

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Answer: My reaction is that the broker is suggesting you commit banking fraud. Stop and think about what it means to "take me off the LLC paperwork just until the loan is approved". If I understand the suggestion correctly, at all times you will be the true beneficial owner of a 1/3rd interest in the LLC; however, the broker recommends submitting loan applications to banks showing just two LLC members each having a 50% interest. It is a federal crime to lie on a loan application to a federally insured bank. See Lying on mortgage application can lead to a fine and even jail time.

I'm not sure what problem a bank has with your bad credit if the other two members have good credit. Normally, all owners "jointly and severally" guaranty small business loans. That means the bank can recover the full amount of the loan to the LLC from any member. If the issue is that the bank does not wish one with bad credit to have control over the money loaned, then perhaps there is another way to deal with the situation. The LLC could be converted to a manager-managed LLC. Then the two members with good credit are made the managers. You are left a member but not a manager. For good measure, the LLC operating agreement could state that only managers may have signature authority over LLC financial accounts. Not sure if this will calm the loan officer's fears but it never hurts to inquire. Lying is not an option.

Dissolving A Maryland LLC

Question: I co-own a Maryland LLC with three other people. We are looking to dissolve and do not know where to begin. Where can we find the best information, and where is the best place to start? Are the Articles of Cancellation the same as the Articles of Dissolution? Stephalauren, Maryland

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Response: In responding, I'll assume all members wish to dissolve the LLC. Basically, here are the steps to a voluntary dissolution of an LLC in Maryland--(a) members unanimously vote to dissolve the LLC, (b) file articles of dissolution with the Maryland Department of Assessments & Taxation, (c) wind-up the business, sell all assets not to be distributed to owners or creditors, pay the credit and, if any assets are leftover, distribute remaining assets to the members and (d) file articles of LLC cancellation with the Maryland Department of Assessments & Taxation. This information was gleaned from reading Subtitle 9. Dissolution, Forfeiture, and Reinstatement. of the Maryland LLC Act. In many states, those wishing to dissolve an LLC must also get a tax clearance letter from the state certified that they have paid all of the business entity's state tax obligations before the state officially dissolves the LLC. I would contact the Maryland Corporate Charter Division to ask whether I've left anything off the list: charterhelp@dat.state.md.us.

Here is a link to the official form for articles of LLC cancellation. There does not appear to be a recommended form for LLC articles of dissolution on the state website but that should pose no large hurdle. The contents of the articles of dissolution are rather straight forward as set out in Maryland LLC Act §4A–907.

(2) Articles of dissolution shall contain:
      (i) The name of the limited liability company;
      (ii) The date of filing of the articles of organization and each amendment thereto;
      (iii) The date of the dissolution; and
      (iv) Any other information the members determine.

As to the order of priority in distribution of the LLC's assets during the windup process, this is specified in Maryland LLC Act §4A–906.

Pro Se Representation of LLCs

Question: We have come across some judges classifying an LLC as a type of corporation or an association which requires the use of an attorney for representation in court. Can an LLC represent itself through one of it's members (partnership) or through it's sole member (single member LLC) pro se without a lawyer in a court of law or other civil proceeding? Herman, New York.

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Response: "The general rule for corporate representation is that corporations, as 'artificial entities, may only appear in court through an attorney.' Thus, any non-lawyer representing the corporation engages in 'the unauthorized practice of law.'" Link. LLCs with more than one member are clearly artificial legal entities that the law will treat no different than partnership, which must be represented by a lawyer in court. However, what about single-member LLCs? The IRS allows a single-member LLC to be disregarded for tax purposes (and treated as a sole proprietorship). It would seem to make sense that single member LLCs should be excepted from the general rule such that the sole member is allowed to represent the LLC in court. That argument was expressly rejected by the federal Court of Appeals in Lattanzio v. COMTA, 481 F.3d 137 (2nd Cir. 2007); see also Collier v. Cobalt LLC, 2002 WL 726640 (E.D. La. 2002). I'm not aware of a reported case where a court has allowed a single member LLC to proceed pro se (without a lawyer).